Are rate cuts a gamechanger for funding levels?

The time has come, as it comes to many in my profession. 20 years into my career and I’ve bitten the bullet. I’m finally reading Liar’s Poker (the seminal expose of the 1980s bond markets by Michael Lewis, later of “The Big Short” fame). 

The premise of the game is fairly simple: each player holds a dollar bill and must bet on / predict the least number of times a number (say 5s or 6s) appears across all the 8-digit serial numbers of the group’s notes. 

Each subsequent person’s guess must be higher in quantity or equal in quantity and higher in value than the previous bid. So ‘three 5s’ could be followed by ‘three 6s’ or ‘four 5s’ say. Or if all players challenge the previous bidder the ‘correct”’ number is revealed – a game of strategy and probability but also reading the other players reactions to the bidding – so a perfect analogy to bond markets and the timing of liability hedging.

“The only thing history teaches us, a wise man once said, is that history doesn’t teach us anything.” - Liar’s Poker

So why am I quoting a 35-year old book on markets? A lot has changed since Lewis wrote his book, market cycles and crises have come and gone, but the bond markets remain as riveting and as relevant a topic as they have ever been (at least so I tell people at dinner parties).

Could history replay?

In interest rates historically, long-end yields have often followed the short end (see chart). So market expectations of rates cuts can potentially drive longer-dated rate expectations. 

Rate cuts have also sometimes coincided with equity market declines (cf. 2008 and 2020, as shown in the chart below. So what does this mean for pension scheme hedge ratios?

By examining the asset allocation of a typical pension scheme[1] we can estimate what impact certain scenarios would have on a scheme 100% funded on a buyout basis (£1bn assets / liabilities). 

We estimate our average client interest rates and inflation hedge ratios to be ~80% on a buyout[2] basis.

Endgame scenario analysis

Under the scenarios laid out in the table below we can see how much schemes could become underhedged versus buyout funding in ‘rates down, risky assets down’ scenarios.

Would a drop of 10% in funding level (scenario 2) be enough to change the endgame for a scheme? A lot of factors come in to answering this, but it could alter levels of demand in the gilt market and require companies to fund the difference if buyout was the aim.

The Bank of England met in September and although there was no cut at that meeting, there are 170bps (1.7%) of cuts priced by the end of 2026[3]. And yes, these cuts should already be reflected in the price of longer-dated yields. However, history has shown that the market can potentially over/ under-price this effect. 

“The questions a Liar’s Poker player asks himself are, up to a point, the same questions a bond trader asks himself. Is this a smart risk? Do I feel lucky?” 

Will history teach us anything this time round?

 

As a reminder our clients and their advisers can access their collateral sufficiency metrics (and more) on a daily basis on our online portal, LGIM Connect.

Additionally, for monthly commentary on the latest moves in LDI markets, please see our recently refreshed Solutions Monthly Wrap.  

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[1] PPF Purple book 2023 asset allocation
[2] Based on L&G Asset Management Affordability Index / data
[3] Bloomberg, 19 September 2024